Lecture notes for week 5

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30 Nov 2010
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FISCAL POLICY AS AN AUTOMATIC STABILIZER AND THE AS-AD MODEL
Outline
x Discuss the concepts like inflationary gap, deflationary gap, and full-employment level of output.
x The use of fiscal policy to smooth out business cycles.
x Develop the AS-AD modelâ€”bringing price into the model.
Our Extended Modelâ€”the Budget Balance Again
x Our extended model (let IM0 = 0 and hold r & E constant):
C = C0 + c1DI
T = T0 + t1Y, 1 > t1 > 0
TR = TR0 â€“ tr1Y, 1 > tr1 > 0
I = I0
G
X = X0
IM = im1Y
AE = AE0 + cYY, where AE0 = C0 + I0 + G + X0 + c1TR0 â€“ c1T0
c
Y = [c1 (1 â€“ t1 â€“ tr1) â€“ im1]
BB = (T0 â€“ TR0 â€“ G) + (t1 + tr1) Y
x Question: What happens to the budget balance when Y changes?
x Answer: Holding all else constant (T0, TR0, and G are all held constant), when Y increases, BB increases. Similarly, when Y
decreases, BB decreases. The budget balance is ENDOGENOUS (it responds to a change in Y)!
o A change in G, T0, or TR0 would have TWO effects on the BB. Why?
BB = (T0 â€“ TR0 â€“ G) + (t1 + tr1) Y
o When T0 decreases, TR0 increases, or G increases, this will cause (T0 â€“ TR0 â€“ G) to decrease Ă† BB decreases. (FIRST
ROUND EFFECT)
o When T0 decreases, TR0 increases, or G increases (change in AE0), this leads to a higher level of AE Ă† Y increases Ă† (t1 +
tr1) Y increases Ă† BB increases. (SECOND ROUND EFFECT)
o First round effect dominates the second round effect.
Full-Employment Level of Output and Output Gaps
Full-Employment Level of Output, YFE
x It is the level of output consistent with â€śfull employmentâ€ť.
x The term â€śfull employmentâ€ť means
o â€śGoodâ€ť (productive) workers find it â€śeasyâ€ť to find a job.
o â€śYoungâ€ť (inexperienced) workers find it â€śeasyâ€ť to find their first job.
o â€śOldâ€ť (experienced) workers are not forced out of the labour force if they lose their jobs (i.e., no discouraged workers).
x In other words, when the economy is operating at its normal pace (not too fast and not too slow), then we can say that the economy
is at its full employment.
x The unemployment rate at YFE is called the non-accelerating inflation rate of unemployment (NAIRU) or natural rate of
unemployment (NRU).
x Full employment DOES NOT mean that everyone is working because
o Frictional unemploymentâ€”unemployment that results from the turnover in the labour market as workers move between jobs.
o Structural unemploymentâ€”long-term and chronic unemployment arising from imbalances between the skills and other
characteristics of workers in the market and the needs of employers.
o The labour market is dynamic (people move in and out of the labour market).
o There are â€śfrictionsâ€ť in the economy (some industries/regions expand while some industries/regions contract).
Recessionary or Deflationary Gap
x It occurs when the equilibrium level of output (Y*) is less than the full-employment level, i.e., Y* < YFE.
x This means that the economy is producing less output than is normally associated with full employment.
x How? Firms lay off their workers (i.e. many unemployed workers).
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x When the economy has lots of unemployed workers, we say we are in a recession Ă† Recessionary gap.
x If the gap is large enough, there will be pressure for prices to fall Ă† Deflationary gap.
Inflationary Gap
x It occurs when the equilibrium level of output (Y*) is greater than the full-employment level, i.e., Y* > YFE.
x This means that the economy is producing more output than is normally associated with full employment.
x How? Hire more workers or ask their workers to work over time.
x The economy is â€śtoo hotâ€ť! The economy overheats Ă† there will be pressure for prices to rise Ă† Inflationary gap.
Endogenous Budget Balance & Output Gaps
x In this section, we connect the notion of output gaps with the notion of endogenous budget balance.
Relationship between Budget Balance and National Debt
x Recall, BB = T â€“ TR â€“ G.
o If BB < 0, the government runs a budget deficit.
o If BB > 0, the government runs a budget surplus.
x However, each time when the government runs a budget deficit, it needs to find ways to finance its deficit.
x Question: How does the government finance its deficit?
x Answer: Borrowing (issue government bonds)
x Question: What is the problem if the government runs persistent budget deficit?
x Answer: Every time the government borrows from the public, the stock of national debt increases.
o This debt must be â€śservicedâ€ť, i.e., the government has to pay interest on its debt (there is no free lunch).
o This interest payment uses up some tax revenue needed to run public programs.
o Government has to cut services (decrease funding on some programs or cancel some programs) or increase taxes or do both.
o Program cuts hurt Canadians. Higher taxes also hurt us (remember excess burden from ECMA04).
* Luckily, most of the government bonds are held by Canadians (i.e. we owe ourselves money).
x Letâ€™s agree that persistent budget deficits are bad since national debt increases.
Structural Deficit vs. Cyclical Deficit
x The budget balance, BB = (T0 â€“ TR0 â€“ G) + (t1 + tr1) Y, is endogenous; it changes automatically when Y changes.
x Implication: We need to separate a deficit during a recession which is natural from a persistent deficit even if the economy is
operating at full employment (which is bad).
x If the government runs a deficit when Y = YFE, then we have a structural deficit.
x If there is no deficit or surplus at YFE, but the government runs the occasional deficit when Y < YFE, then we have a cyclical deficit.
x In other words, we need to worry if we have a structural deficit but not to worry if we have cyclical deficit.
x Ideally, we should run surpluses during good times (when Y > YFE) and deficits during bad times (when Y < YFE).
Relationship between Output Gaps and Budget Balances
x Assumption: There is no structural deficit, i.e., BB = 0 when Y = YFE.
x We ask the question: What do we do if there is a deflationary/recessionary gap or an inflationary gap?
o Can the government do something about it?
x The answer is YES! The government can adjust its balance to bring Y back to YFE.
x Recall, AE = AE0 + cYY, where AE0 = C0 + I0 + G + X0 + c1TR0 â€“ c1T0
c
Y = c1 (1 â€“ t1 â€“ tr1) â€“ im1
x Changes in G, TR0, or T0 will affect AE0. A change in AE0 will lead to a change in Y*. (There is room for the government to use
fiscal policy to smooth out the business cycle.)
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Document Summary

Fiscal policy as an automatic stabilizer and the as-ad model. N discuss the concepts like inflationary gap, deflationary gap, and full-employment level of output. N develop the as-ad model bringing price into the model. The use of fiscal policy to smooth out business cycles. N our extended model (let im0 = 0 and hold r & e constant): Tr = tr0 tr1y, 1 > tr1 > 0. Ae = ae0 + cyy, where ae0 = c0 + i0 + g + x0 + c1tr0 c1t0 cy = [c1 (1 t1 tr1) im1] Bb = (t0 tr0 g) + (t1 + tr1) y. N answer: holding all else constant (t0, tr0, and g are all held constant), when y increases, bb increases. The budget balance is endogenous (it responds to a change in y): a change in g, t0, or tr0 would have two effects on the bb.

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